CHAPTER 9. Inventories: Additional Valuation Issues. 3. Purchase commitments. 9 7, 8 11,

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CHAPTER 9

Inventories: Additional Valuation Issues

ASSIGNMENT CLASSIFICATION TABLE (BY TOPIC)

Topics Questions

Brief

Exercises Exercises Problems

Concepts for Analysis 1. Lower-of-cost-or-NRV. 1, 2, 3, 4, 5 1, 2, 3 1, 2, 3, 4, 5, 6 1, 2, 3, 10, 11 1, 2, 3, 5 2. Inventory accounting changes; relative sales value method; net real-izable value.

6, 7, 8 4, 5, 6 7, 8, 9, 10 4

3. Purchase commitments. 9 7, 8 11, 12 10 6 4. Gross profit method. 10, 11,

12, 13

9 13, 14, 15, 16, 17, 18, 19

5, 6

5. Retail inventory method. 14, 15, 16 10 20, 21, 21 7, 8, 9 4, 5

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ASSIGNMENT CLASSIFICATION TABLE (BY LEARNING OBJECTIVE)

Learning Objectives

Brief

Exercises Exercises Problems

1. Describe and apply the lower-of-cost-or-NRV rule. 1, 2, 3 1, 2, 3, 4, 5, 6

1, 2, 3, 10, 11 2. Explain when companies value inventories at net

realizable value.

4, 5 7, 8 4

3. Explain when companies use the relative sales value method to value inventories.

6 9, 10

4. Discuss accounting issues related to purchase commitments.

7, 8 11, 12 10

5. Determine ending inventory by applying the gross profit method.

9 13, 14, 15, 16, 17, 18, 19

5, 6

6. Determine ending inventory by applying the retail inventory method.

10 20, 21, 22 7, 8, 9

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ASSIGNMENT CHARACTERISTICS TABLE Item Description Level of Difficulty Time (minutes) E9-1 LCNRV. Simple 15–20 E9-2 LCNRV. Simple 10–15 E9-3 LCNRV. Simple 15–20

E9-4 LCNRV—journal entries. Simple 10–15 E9-5 LCNRV—valuation account. Moderate 20–25 E9-6 LCNRV—error effect. Simple 10–15 E9-7 Valuation at net realizable value. Simple 10-15 E9-8 Valuation at net realizable value. Simple 10-15 E9-9 Relative sales value method. Simple 15–20 E9-10 Relative sales value method. Simple 12–17 E9-11 Purchase commitments. Simple 05–10 E9-12 Purchase commitments. Simple 15–20 E9-13 Gross profit method. Simple 8–13 E9-14 Gross profit method. Simple 10–15 E9-15 Gross profit method. Simple 15–20 E9-16 Gross profit method. Moderate 15–20 E9-17 Gross profit method. Simple 10–15 E9-18 Gross profit method. Simple 15–20 E9-19 Gross profit method. Moderate 20–25 E9-20 Retail inventory method. Moderate 20–25 E9-21 Retail inventory method. Simple 12–17 E9-22 Retail inventory method. Simple 20–25 E9-23 Analysis of inventories. Simple 10–15

P9-1 LCNRV. Simple 10–15

P9-2 LCNRV. Moderate 25–30

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ASSIGNMENT CHARACTERISTICS TABLE (Continued) Item Description Level of Difficulty Time (minutes)

P9-9 Retail inventory method. Moderate 20–30 P9-10 Statement and note disclosure, LCNRV, and purchase

commitment. Moderate 30–40 P9-11 LCNRV. Moderate 30–40 CA9-1 LCNRV. Moderate 15–25 CA9-2 LCNRV. Moderate 20–30 CA9-3 LCNRV. Moderate 15–20

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ANSWERS TO QUESTIONS

1. Where there is evidence that the utility of goods to be disposed of in the ordinary course of

business will be less than cost, the difference should be recognized as a loss in the current period, and the inventory should be stated at net realizable value in the financial statements.

2. The usual basis for carrying forward the inventory to the next period is cost. Departure from cost is

required; however, when the utility of the goods included in the inventory is less than their cost. This loss in utility should be recognized as a loss of the current period, the period in which it occurred. Furthermore, the subsequent period should be charged for goods at an amount that measures their expected contribution to that period. In other words, the subsequent period should be charged for inventory at prices no higher than those which would have been paid if the inventory had been obtained at the beginning of that period. (Historically, the lower-of-cost-or-net realizable value rule arose from the accounting convention of providing for all losses and anticipating no profits.)

In accordance with the foregoing reasoning, the rule of “cost or net realizable value, whichever is lower” may be applied to each item in the inventory, to the total of the components of each major category, or to the total of the inventory, whichever most clearly reflects operations. The rule is usually applied to each item, but if individual inventory items enter into the same category or categories of finished product, alternative procedures are suitable.

The arguments against the use of the lower-of-cost-or-net realizable value method of valuing inventories include the following:

(a) The method requires the reporting of estimated losses (all or a portion of the excess of actual cost over net realizable value) as definite income charges even though the losses have not been sustained to date and may never be sustained. Under a consistent criterion of realization a drop in net realizable value below original cost is no more a sustained loss than a rise above cost is a realized gain.

(b) A price shrinkage is brought into the income statement before the loss has been sustained through sale. Furthermore, if the charge for the inventory write-downs is not made to a special loss account, the cost figure for goods actually sold is inflated by the amount of the estimated shrinkage in price of the unsold goods. The title “Cost of Goods Sold” therefore becomes a misnomer.

(c) The method is inconsistent in application in a given year because it recognizes the propriety of implied price reductions but gives no recognition in the accounts or financial statements to the effect of the price increases.

(d) The method is also inconsistent in application in one year as opposed to another because the inventory of a company may be valued at cost in one year and at net realizable value in the next year.

(e) The lower-of-cost-or-net realizable value method values the inventory in the statement of financial position conservatively. Its effect on the income statement, however, may be the opposite. Although the income statement for the year in which the unsustained loss is taken is stated conservatively, the net income on the income statement of the subsequent period may be distorted if the expected reductions in sales prices do not materialize.

3. The lower-of-cost-or-net realizable value rule may be applied directly to each item or to the total of

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Questions Chapter 9 (Continued) 4. (1) $12.80. (2) $16.10. (3) $13.00. (4) $9.20. (5) $15.90.

5. One approach is to record the inventory at cost and then reduce it to net realizable value, thereby

reflecting a loss in the current period (often referred to as the loss method). The loss would then be shown as a separate item in the income statement and the cost of goods sold for the year would not be distorted by its inclusion. An objection to this method of valuation is that an inconsistency is created between the income statement and balance sheet. Companies may record the adjustment either directly to the Inventory account or use the Allowance to Reduce Inventory to Market which is a contra account against inventory on the statement of financial position.

Another approach is merely to substitute market for cost when pricing the new inventory (often referred to as the cost of goods sold method). Such a procedure increases cost of goods sold by the amount of the loss and fails to reflect this loss separately. For this reason, many theoretical objections can be raised against this procedure.

6. An exception to the normal recognition rule occurs where the inventory consists of (1) agricultural

assets, and (2) commodities held by borker-traders. Some minerals and minerals products may be valued at NRV.

7. (a) Biological assets are measured on initial recognition and at the end of each reporting period at

fair value less costs to sell (NRV). Companies record a gain or loss due to changes in the NRV of biological assets in income when it arises.

(b) Agricultural produce (which are harvested from biological assets) are measured at fair value less costs to sell (NRV) at the point of harvest. Once harvested, the NRV of the agricultural produce becomes its cost and this asset is accounted for similar to other inventories held for sale in the normal course of business.

8. Relative sales value is an appropriate basis for pricing inventory when a group of varying units is

purchased at a single lump-sum price (basket purchase). The purchase price must be allocated in some manner or on some basis among the various units. When the units vary in size, character, and attractiveness, the basis for allocation must reflect both quantitative and qualitative aspects. A suitable basis then is the relative sales value of the units that comprise the inventory.

9. The drop in the market price of the commitment should be charged to operations in the current year

if it is material in amount. The following entry would be made [(£6.20 – £5.90) X 150,000] = £45,000: Unrealized Holding Gain or Loss—Income (Purchase Commitments)... 45,000

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Questions Chapter 9 (Continued)

11. Gross profit as a percentage of sales indicates that the margin is based on selling price rather than

cost; for this reason the gross profit as a percentage of selling price will always be lower than if based on cost. Conversions are as follows:

25% on cost = 20% on selling price 33 1/3% on cost = 25% on selling price 33 1/3% on selling price = 50% on cost

60% on selling price = 150% on cost

12. A markup of 25% on cost equals a 20% markup on selling price; therefore, gross profit equals

$1,000,000 ($5 million X 20%) and net income equals $250,000 [$1,000,000 – (15% X $5 million)]. The following formula was used to compute the 20% markup on selling price:

Percentage markup on cost .25 Gross profit on selling price =

100% + Percentage markup on cost = 1 + .25 = 20%

13. Inventory, January 1, 2011 ... $ 400,000 Purchases to February 10, 2011 ... $1,140,000

Freight-in to February 10, 2011 ... 60,000 1,200,000 Merchandise available... 1,600,000 Sales to February 10, 2011 ... 1,950,000

Less gross profit at 40%... 780,000

Sales at cost ... 1,170,000 Inventory (approximately) at February 10, 2011 ... $ 430,000

14. The validity of the retail inventory method is dependent upon (1) the composition of the inventory

remaining approximately the same at the end of the period as it was during the period, and (2) there being approximately the same rate of markup at the end of the year as was used throughout the period.

The retail method, though ordinarily applied on a departmental basis, may be appropriate for the business as a unit if the above conditions are met.

15. The conventional retail method is a procedure based on averages whereby inventory figures at

retail are reduced to an inventory valuation figure by multiplying the retail figures by a percentage which is the complement of the markup percent.

To determine the markup percent, original markups and additional net markups are related to the original cost. The complement of the markup percent is then applied to the inventory at retail after the latter has been reduced by net markdowns, thus in effect achieving a lower-of-cost-or-NRV valuation.

An example of reduction to market follows:

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The inventory at $15.33 is $4.67 below original cost and is valued at an amount which will produce the “normal” 33 1/3% gross profit if sold at the present retail price of $23.00.

Computation of Inventory

Cost Retail Ratio

Purchases $100 $150 66 2/3%

Sales (120)

Markdowns (20 X $.35) (7) Inventory at retail $ 23 Inventory at lower-of-cost-or-market $23 X 66 2/3% = $15.33

16. (a) Ending inventory:

Cost Retail Beginning inventory ... ¥ 149,000 ¥ 283,500 Purchases ... 1,400,000 2,160,000 Freight-in ... 70,000 —

Totals... 1,619,000 2,443,500 Add net markups ... — 92,000 ¥1,619,000 2,535,500 Deduct net markdowns... 48,000 2,487,500 Deduct sales... 2,175,000 Ending inventory, at retail ... ¥ 312,500

¥1,619,000 Ratio of cost to selling price

¥2,535,500 = 64%.

Ending inventory estimated at cost = 64% X ¥312,500 = ¥200,000.

(b) The retail method, above, showed an ending inventory at retail of ¥312,500; therefore, mer-chandise not accounted for amounts to ¥17,500 (¥312,500 – ¥295,000) at retail and ¥11,200 (¥17,500 X .64) at cost.

17. The accounting policies adopted in measuring inventories, including the cost formula used

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18. Inventory turnover measures how quickly inventory is sold. Generally, the higher the inventory

turnover, the better the enterprise is performing. The more times the inventory turns over, the smaller the net margin can be to earn an appropriate total profit and return on assets. For example, a company can price its goods lower if it has a high inventory turnover. A company with a low profit margin, such as 2%, can earn as much as a company with a high net profit margin, such as 40%, if its inventory turnover is often enough. To illustrate, a grocery store with a 2% profit margin can earn as much as a jewelry store with a 40% profit margin and an inventory turnover of 1 if its turnover is more than 20 times.

19. Key Similarities are (1) the guidelines on who owns the goods—goods in transit, consigned

goods, special sales agreements, and the costs to include in inventory are essentially accounted for the same under IFRS and U.S. GAAP; (2) use of specific identification cost flow assumption, where appropriate; (3) unlike property plant and equipment, IFRS does not permit the option of valuing inventories at fair value. As indicated above, IFRS requires inventory to be written down, but inventory cannot be written up above its original cost; (4) certain agricultural products and minerals and mineral products can be reported at net realizable value using IFRS.

Key differences are related to (1) the LIFO cost flow assumption—U.S. GAAP permits the use of

LIFO for inventory valuation. IFRS prohibits its use. FIFO and average-cost are the only two acceptable cost flow assumptions permitted under IFRS; (2) lower-of-cost-or-market test for inventory valuation—IFRS defines market as net realizable value. U.S. GAAP on the other hand defines market as replacement cost subject to the constraints of net realizable value (the ceiling) and net realizable value less a normal markup (the floor). That is, IFRS does not use a ceiling or a floor to determine market; (3) inventory write-downs—under U.S. GAAP, if inventory is written down under the lower-of-cost-or-market valuation, the new basis is now considered its cost. As a result, the inventory may not be written back up to its original cost in a subsequent period. Under IFRS, the write-down may be reversed in a subsequent period up to the amount of the previous write-down. Both the write-down and any subsequent reversal should be reported on the income statement; (4) The requirements for accounting and reporting for inventories are more principles-based under IFRS. That is, U.S. GAAP provides more detailed guidelines in inventory accounting.

20. As shown in the analysis below, under IFRS, LaTour’s inventory turnover ratio is computed as

follows:

Cost of Goods Sold Average Inventory =

578 15 €

€ 44=3.75 or approximately 97 days (365 ÷ 3.75)..

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21. Reed must not be aware the important convergence issue arising from the use of the LIFO cost

flow assumption; IFRS specifically prohibits its use. Conversely, the LIFO cost flow assumption is widely used in the United States because of its favorable tax advantages. In addition, many argue that LIFO from a financial reporting point of view provides a better matching of current costs against revenue and therefore a more realistic income is computed.

The problem is compounded in the United States because LIFO cannot be used for tax purposes unless it is used for financial reporting purposes. As a result, unless the tax law is changed, it is unlikely that U.S. GAAP will eliminate the use of the LIFO cost flow assumption because of its substantial tax advantages for many companies.

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SOLUTIONS TO BRIEF EXERCISES

BRIEF EXERCISE 9-1 Item Cost NRV LCNRV Skis $190.00 $161.00 $161.00 Boots 106.00 108.00 106.00 Parkas 53.00 50.00 50.00 BRIEF EXERCISE 9-2

(a) Item Cost NRV LCNRV

Item-by-item Jokers € 2,000 € 2,100 € 2,000 Penguins 5,000 4,950 4,950 Riddlers 4,400 4,625 4,400 Scarecrows 3,200 3,830 3,200 Total €14,600 €15,505 €14,550 (b) 1. Penguins only: €50

2. None on a whole group: €15,505 > €14,600.

BRIEF EXERCISE 9-3

(a) Cost-of-goods-sold-method

Cost of Goods Sold ... 21,000,000

Allowance to Reduce Inventory to NRV ... 21,000,000

(b) Loss method

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Biological Assets – Shearing Sheep... 4,125*

Unrealized Holding Gain or Loss – Income ... 4,125 *€4,700 – €575 = €4,125.

Wool Inventory ... 9,000

Unrealized Holding Gain or Loss – Income ... 9,000 Cash ... 10,500

Cost of Goods Sold... 9,000

Wool Inventory... 9,000 Sales ... 10,500 BRIEF EXERCISE 9-6 Group Number of CDs Sales Price per CD Total Sales Price Relative Sales Price Total Cost Cost Allocated to CDs Cost per CD 1 100 ¥ 5 ¥ 500 5/100* X ¥8,000 = ¥ 400 ¥ 4** 2 800 ¥10 8,000 80/100 X ¥8,000 = 6,400 ¥ 8 3 100 ¥15 1,500 15/100 X ¥8,000 = 1,200 ¥12 ¥10,000 ¥8,000 *¥500/¥10,000 = 5/100 **¥400/100 = ¥4 BRIEF EXERCISE 9-7

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Purchases (Inventory) ... 950,000 Purchase Commitment Liability... 50,000

Cash... 1,000,000

Beginning inventory... €150,000 Purchases... 500,000 Cost of goods available ... 650,000 Sales ... €700,000

Less gross profit (35% X €700,000)... 245,000

Estimated cost of goods sold ... 455,000 Estimated ending inventory destroyed in fire ... €195,000

BRIEF EXERCISE 9-10 Cost Retail Beginning inventory... $ 12,000 $ 20,000 Net purchases ... 120,000 170,000 Net markups... — 10,000 Totals... $132,000 200,000 Deduct: Net markdowns ... 7,000 Sales ... 147,000 Ending inventory at retail ... $ 46,000

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Inventory turnover:

€68,709.4

€6,891 + €6,867 = 10.0 times 2

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SOLUTIONS TO EXERCISES

EXERCISE 9-1 (15–20 minutes)

Per Unit

Lower-of-Part No. Quantity Cost NRV

Total Cost Total NRV Cost-or-NRV 110 600 $ 95 $100.00 $ 57,000 $ 60,000 $ 57,000 111 1,000 60 52.00 60,000 52,000 52,000 112 500 80 76.00 40,000 38,000 38,000 113 200 170 180.00 34,000 36,000 34,000 120 400 205 208.00 82,000 83,200 82,000 121 1,600 16 1.00 25,600 1,600 1,600 122 300 240 235.00 72,000 70,500 70,500 Totals $370,600 $341,300 $335,100 (a) $335,100. (b) $341,300. EXERCISE 9-2 (10–15 minutes) Item Net Realizable Value Cost LCNRV D €80* €75 €75 E 62 80 62 F 60 80 60 G 35 80 35 H 70 50 50 I 40 36 36

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EXERCISE 9-3 (15–20 minutes) Item No. Cost per Unit Net Realizable Value LCNRV Quantity Final Inventory Value 1320 $3.20 $2.90* $2.90 1,200 $ 3,480 1333 2.70 2.40 2.40 900 2,160 1426 4.50 3.60 3.60 800 2,880 1437 3.60 1.85 1.85 1,000 1,850 1510 2.25 1.85 1.85 700 1,295 1522 3.00 3.10 3.00 500 1,500 1573 1.80 1.30 1.30 3,000 3,900 1626 4.70 4.50 4.50 1,000 4,500 $21,565 *$4.50 – $1.60 = $2.90. EXERCISE 9-4 (10–15 minutes)

(a) 12/31/10 Cost of Goods Sold ... 24,000 Allowance to Reduce

Inventory to NRV ... 24,000

12/31/11 Allowance to Reduce

Inventory to NRV... 4,000

(b) 12/31/10 Loss Due to Decline of

Inventory to NRV ... 24,000 Allowance to Reduce

Inventory to NRV ... 24,000

12/31/11 Allowance to Reduce

Inventory to NRV... 4,000*

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EXERCISE 9-4 (Continued)

*Cost of inventory at 12/31/10 ... £346,000 LCNRV at 12/31/10 ... (322,000) Allowance amount needed to reduce inventory

to NRV (a) ... £ 24,000

Cost of inventory at 12/31/11 ... £410,000 LCNRV at 12/31/11 ... (390,000) Allowance amount needed to reduce inventory

to NRV (b)... £ 20,000

Recovery of previously recognized loss = (a) – (b)

= £24,000 – £20,000 = £4,000.

(c) Both methods of recording lower-of-cost-or-NRV adjustments have the same effect on net income.

(a) February March April

Sales $29,000 $35,000 $40,000

Cost of goods sold

Inventory, beginning 15,000 15,100 17,000

Purchases 17,000 24,000 26,500

Cost of goods available 32,000 39,100 43,500

Inventory, ending 15,100 17,000 14,000

Cost of goods sold 16,900 22,100 29,500

Gross profit 12,100 12,900 10,500

Gain (loss) due to market

fluctuations of inventory* (2,000) 1,100 700

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* Jan. 31 Feb. 28 Mar. 31 Apr. 30

Inventory at cost $15,000 $15,100 $17,000 $14,000

Inventory at LCNRV (14,500) (12,600) (15,600) (13,300)

Allowance amount needed to

reduce inventory to NRV $ 500 $ 2,500 $ 1,400 $ 700

Gain (loss) due to market

fluctuations of inventory** $ (2,000) $ 1,100 $ 700

**$500 – $2,500 = $(2,000) $2,500 – $1,400 = $1,100 $1,400 – $700 = $700

(b) Jan. 31 Loss Due to Decline of Inventory to NRV... 500 Allowance to Reduce

Inventory to NRV ... 500 Feb. 28 Loss Due to Decline of Inventory to NRV... 2,000

Allowance to Reduce

Inventory to NRV ... 2,000 Mar. 31 Allowance to Reduce Inventory to NRV... 1,100

Recovery of Inventory Loss ... 1,100 Apr. 30 Allowance to Reduce Inventory to NRV... 700

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Net realizable value €50 – €14 = €36

Net realizable value less normal profit €36 – € 9 = €27

Cost €40

Lower-of-cost-or-NRV €36

€38 figure used – €36 correct value per unit = €2 per unit. €2 X 1,000 units = €2,000.

If ending inventory is overstated, net income will be overstated. If beginning inventory is overstated, net income will be understated.

Therefore, net income for 2010 was overstated by €2,000 and net income for 2011 was understated by €2,000.

(a) Unrealized Holding Gain or Loss – Income ... 212,000

Biological Assets – Milking Cows ... 212,000

(b) Milk Inventory ... 72,000

Unrealized Holding Gain or Loss – Income... 72,000

(c) Cash... 74,000 Cost of Goods Sold ... 72,000

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(a) Biological Assets – Shearing Alpaca ... 6,725

Unrealized Holding Gain or Loss – Income ... 6,725

(b) Wool Inventory... 13,000

Unrealized Holding Gain or Loss – Income ... 13,000

Wool Inventory... 13,000 Sales... 14,500 (d) (1) The birth of a baby Alpaca may result in a gain on the initial

recognition of the biological asset.

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Cost Per Lot

(Cost Allocated/ No. of Lots) $2,040 2,720 1,360 Cost Allocated to Lots $18,360 40,800 25,840 $85,000 Total Cost $85,000 85,000 85,000 X X X Relative Sales Price $27,000/$125,000 $60,000/$125,000 $38,000/$125,000 $78,000 53,040 24,960 18,200 _$ 6,760 Gross Profit _{$ 3,840} _10,240 _10,880 $24,960

Total Sales Price

$ 27,000 60,000 38,000 $125,000 Sales $12,000 32,000 34,000 $78,000

Sales

Price Per Lot

$3,000 4,000 2,000

Cost Cost of Per Lots Lot Sold $2,040

$ 8,160 2,720 21,760 1,360 23,120 $53,040 No. of Lots 9 15 19 4 8 17 29

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Cost per Chair

£54 48 30 Cost Allocated to Chairs £21,600 14,400 24,000 £60,000 Total Cost £60,000 60,000 60,000 _Gross Profit _{£ 7,200} _3,200 _2,400 £12,800 X X X Relative Sales Price £36,000/£100,000 £24,000/£100,000 £40,000/£100,000 Sales _£18,000 _8,000 _6,000 £32,000

Total _Sales Price _£36,000 _24,000 _40,000

£100,000 Cost of Chairs

Sold

£10,800 4,800 3,600 £19,200

Sales

Price per Chain

£90 80 50 _Cost _per

Chair £54 48 30

No. of _Chairs 400 300 800 200 100 120

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Unrealized Holding Gain or Loss—Income ... 25,000

Purchase Commitment Liability ... 25,000

(a) If the commitment is material in amount, there should be a footnote in the balance sheet stating the nature and extent of the commitment. The footnote may also disclose the market price of the materials. The excess of market price over contracted price is a gain contingency that should not be recognized in the accounts until it is realized.

(b) The drop in the market price of the commitment should be charged to operations in the current year if it is material in amount. The following entry would be made:

Unrealized Holding Gain or Loss—Income ... 12,000

Purchase Commitment Liability ... 12,000 The entry is made because a loss in utility has occurred during the period in which the market decline took place. The account credited in the above entry should be included among the current liabilities on the statement of financial position, with an appropriate footnote indicating the nature and extent of the commitment. This liability indicates the minimum obligation on the commitment contract at the present time—the amount that would have to be forfeited in case of breach of contract.

(c) Assuming the $12,000 market decline entry was made on December 31, 2011, as indicated in (b), the entry when the materials are received in January 2012 would be:

Raw Materials ... 108,000 Purchase Commitment Liability... 12,000

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This entry debits the raw materials at the current cost, eliminates the $12,000 liability set up at December 31, 2011, and records the contrac-tual liability for the purchase. This permits operations to be charged this year with the $108,000, the other $12,000 of the cost having been charged to operations in 2011. EXERCISE 9-13 (8–13 minutes) (1) 20% 100% + 20% = 16.67% OR 16 2/3%. (2) 25% 100% + 25% = 20%. (3) 33 1/3% 100% + 33 1/3% = 25%. (4) 50% 100% + 50% = 33.33% OR 33 1/3%. EXERCISE 9-14 (10–15 minutes)

(a) Inventory, May 1 (at cost) ... €160,000 Purchases (at cost) ... 640,000 Purchase discounts... (12,000) Freight-in ... 30,000

Goods available (at cost) ... 818,000 Sales (at selling price) ... €1,000,000

Sales returns (at selling price) ... (70,000) Net sales (at selling price) ... 930,000 Less: Gross profit (25% of €930,000)... 232,500

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(b) Gross profit as a percent of sales must be computed: 25%

100% + 25% = 20% of sales.

Inventory, May 1 (at cost) ... €160,000 Purchases (at cost)... 640,000 Purchase discounts ... (12,000) Freight-in... 30,000

Goods available (at cost) ... 818,000 Sales (at selling price) ... €1,000,000

Sales returns (at selling price)... (70,000) Net sales (at selling price)... 930,000 Less: Gross profit (20% of €930,000) ... 186,000

Sales (at cost)... 744,000 Approximate inventory,

May 31 (at cost) ... € 74,000

(a) Merchandise on hand, January 1... $ 38,000 Purchases... 92,000 Less: Purchase returns and allowances... (2,400) Freight-in... 3,400

Total merchandise available (at cost)... 131,000 Cost of goods sold*... (90,000) Ending inventory ... 41,000 Less: Undamaged goods ... 10,900 Estimated fire loss ... $ 30,100

33 1/3% *Gross profit =

100% + 33 1/3% = 25% of sales.

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(b) Cost of goods sold = 66 2/3% of sales of $120,000 = $80,000 Total merchandise available (at cost)... [$131,000 [as computed in (a)] – $80,000]

$51,000

Less: Undamaged goods... 10,900 Estimated fire loss ... $40,100

Beginning inventory ... $170,000 Purchases ... 450,000 620,000 Purchase returns ... (30,000) Goods available (at cost) ... 590,000 Sales ... $650,000

Sales returns ... (24,000) Net sales ... 626,000

Less: Gross profit (30% X $626,000)... (187,800) 438,200 Estimated ending inventory (unadjusted for

damage)... 151,800 Less: Goods on hand—undamaged (at cost)

$21,000 X (1 – 30%)... 14,700 Less: Goods on hand—damaged (at net

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Beginning inventory (at cost) ... ¥ 38,000 Purchases (at cost)... 90,000 Goods available (at cost) ... 128,000 Sales (at selling price) ... ¥116,000

Less sales returns ... 4,000 Net sales... 112,000 Less: Gross profit* (20% of ¥112,000)... 22,400

Net sales (at cost)... 89,600 Estimated inventory (at cost)... 38,400 Less: Goods on hand (¥30,500 – ¥6,000) ... 24,500 Claim against insurance company... ¥ 13,900

25% *Computation of gross profit:

100% + 25% = 20% of selling price

Lumber Millwork Hardware

Inventory 1/1/11 (cost) $ 250,000 $ 90,000 $ 45,000

Purchases to 8/18/11 (cost) 1,500,000 375,000 160,000 Cost of goods available 1,750,000 465,000 205,000 Deduct cost of goods sold* 1,640,000 410,000 175,000

Inventory 8/18/11 $ 110,000 $ 55,000 $ 30,000

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Computation for cost of goods sold:*

$2,050,000 Lumber: 1.25 = $1,640,000 $533,000 Millwork: 1.30 = $410,000 $245,000 Hardware: 1.40 = $175,000

*Alternative computation for cost of goods sold:

Markup on selling price: Cost of goods sold:

(29)

EXERCISE 9-19 (20–25 minutes) Ending inventory:

(a) Gross profit is 40% of sales

Total goods available for sale (at cost)... £2,100,000 Sales (at selling price) ... £2,300,000

Less: Gross profit (40% of sales) ... 920,000

Sales (at cost)... 1,380,000 Ending inventory (at cost)... £ 720,000

(b) Gross profit is 60% of cost

60%

100% + 60% = 37.5% markup on selling price

Less: Gross profit (37.5% of sales)... 862,500

Sales (at cost)... 1,437,500 Ending inventory (at cost)... £ 662,500

(c) Gross profit is 35% of sales

Less: Gross profit (35% of sales) ... 805,000

(30)

(d) Gross profit is 25% of cost

25%

100% + 25% = 20% markup on selling price

Less: Gross profit (20% of sales)... 460,000

Sales (at cost) ... 1,840,000 Ending inventory (at cost) ... £ 260,000

(a) Cost Retail

Beginning inventory ... $ 58,000 $100,000 Purchases... 122,000 200,000 Net markups ... — 20,000 Totals... $180,000 320,000 Net markdowns... (30,000) Sales price of goods available ... 290,000 Deduct: Sales ... 186,000 Ending inventory at retail... $104,000

(31)

EXERCISE 9-20 (Continued) (c) 1. Method 3. 2. Method 3. 3. Method 3. (d) 56.25% X $104,000 = $58,500 (e) $180,000 – $58,500 = $121,500 (f) $186,000 – $121,500 = $64,500 EXERCISE 9-21 (12–17 minutes) Cost Retail Beginning inventory... € 200,000 € 280,000 Purchases... 1,425,000 2,140,000 Totals... 1,625,000 2,420,000 Add: Net markups

Markups... €95,000

Markup cancellations... _________ (15,000) 80,000 Totals... €1,625,000 2,500,000

Deduct: Net markdowns

Markdowns ... 35,000

Markdown cancellations ... (5,000) 30,000

Sales price of goods available... 2,470,000

Deduct: Sales ... 2,250,000 Ending inventory at retail ... € 220,000

€1,625,000 Cost-to-retail ratio =

€2,500,000 = 65%

(32)

EXERCISE 9-22 (20–25 minutes) Cost Retail Beginning inventory ... $30,000 $ 46,500 Purchases ... 55,000 88,000 Purchase returns ... (2,000) (3,000) Freight on purchases ... 2,400 _______ Totals ... 85,400 131,500 Add: Net markups

Markups ... $10,000 Markup cancellations ... (1,500)

Net markups ... _______ 8,500 Totals ... $85,400 140,000

Deduct: Net markdowns

Markdowns... 9,300 Markdown cancellations... (2,800)

Net markdowns ... 6,500

Sales price of goods available ... 133,500

Deduct: Net sales ($95,000 – $2,000)... 93,000

Ending inventory, at retail ... $ 40,500

$85,400 Cost-to-retail ratio =

$140,000 = 61%

Ending inventory at cost = 61% X $40,500 = $24,705

EXERCISE 9-23 (10–15 minutes) (a) Inventory turnover:

2008 2007

€7,122 €5,936

(33)

TIME AND PURPOSE OF PROBLEMS

Problem 9-1 (Time 10–15 minutes)

Purpose—to provide the student with an understanding of the lower-of-cost-or-net realizable value approach to inventory valuation, similar to Problem 9-2. The major difference between these problems is that Problem 9-1 provides some ambiguity to the situation by changing the catalog prices near the end of the year.

Purpose—to provide the student with an understanding of the lower-of-cost-or-net realizable value approach to inventory valuation. The student is required to examine a number of individual items and apply the of-cost-or-net realizable value rule and to also explain the use and value of the lower-of-cost-or-net realizable value rule.

Purpose—to provide a problem that requires entries for reducing inventory to lower-of-cost-or-net realizable value under the perpetual inventory system using both the cost of goods sold and the loss method.

Problem 9-4 (Time 15-20 minutes)

Purpose—to provide a problem that requires entries for recording the unrealized gains and losses on biological assets and harvested assets.

Purpose—to provide another problem where a fire loss must be computed using the gross profit method. Certain goods remained undamaged and therefore an adjustment is necessary. In addition, the inventory was subject to an obsolescence factor which must be considered.

Purpose—to provide the student with a complex problem involving a fire loss where the gross profit method must be employed. The problem is complicated because a number of adjustments must be made to the purchases account related to merchandise returned, unrecorded purchases, and shipments in transit. In addition, some cash to accrual computations are necessary.

Purpose—to provide the student with a problem on the retail inventory method. The problem is relatively straightforward although transfers-in from other departments as well as the proper treatment for normal spoilage complicate the problem. A good problem that summarizes the essentials of the retail inventory method.

Purpose—to provide the student with a problem on the retail inventory method. This problem is similar to Problem 9-7, except that a few different items must be evaluated in finding ending inventory at retail and cost. Unusual items in this problem are employee discounts granted and loss from breakage. A good problem that summarizes the essentials of the retail inventory method.

(34)

Time and Purpose of Problems (Continued) Problem 9-10 (Time 30–40 minutes)

Purpose—to provide the student with a problem requiring financial statement and note disclosure of inventories, the income statement disclosure of an inventory market decline, and the treatment of purchase commitments.

(35)

SOLUTIONS TO PROBLEMS

PROBLEM 9-1 Item Cost Net Realizable Value* Lower-of- Cost-or-NRV A $470 $ 450 $450 B 450 430 430 C 830 640 640 D 960 1,000 960

(36)

PROBLEM 9-2

(a) 1. The balance in the Allowance to Reduce Inventory to NRV at May 31, 2010, should be $15,200, as calculated in Exhibit 1 below.

Cost NRV LCNRV

Aluminum siding $ 70,000 $ 56,000 $ 56,000

Cedar shake siding 86,000 84,800 84,800

Louvered glass doors 112,000 168,300 112,000

Thermal windows 140,000 140,000 140,000

Totals $408,000 $449,100 $392,800

Inventory cost $408,000

LCNRV valuation 392,800

Allowance at May 31, 2010 $ 15,200

2. For the fiscal year ended May 31, 2010, the gain that would be recorded due to the change in the Allowance to Reduce Inventory to Net Realizable Value would be $12,300, as calculated below.

(37)

PROBLEM 9-2 (Continued)

(b) The use of the lower-of-cost-or-net realizable value (LCNRV) rule is based on both the expense recognition principle and the concept of conservatism. The expense recognition principle applies because the application of the LCNRV rule allows for the recognition of a decline in the utility (value) of inventory as a loss in the period in which the decline takes place.

(38)

PROBLEM 9-3

(a) 12/31/10 (Cost of Goods Sold Method)

Allowance to Reduce Inventory to NRV ... 68,000

12/31/11

Cost of Goods Sold... 7,000 Allowance to Reduce Inventory to NRV

[($905,000 – $830,000) – $68,000] ... 7,000

(b) 12/31/10 (Loss Method)

To write down inventory to net realizable value:

Loss Due to Decline of Inventory to NRV ... 68,000

Allowance to Reduce Inventory to NRV ... 68,000

12/31/11

To write down inventory to net realizable value:

Loss Due to Decline of Inventory to NRV ... 7,000 Allowance to Reduce Inventory to NRV

(39)

PROBLEM 9-4

(a) Biological Assets—Grape Vineyard... 15,000

Unrealized Holding Gain or Loss – Income... 15,000 (b) Grape Inventory ... 30,000

Unrealized Holding Gain or Loss – Income... 30,000

(40)

PROBLEM 9-5

Beginning inventory ... ¥ 80,000 Purchases ... 290,000 370,000 Purchase returns ... (28,000) Total goods available ... 342,000 Sales ... ¥415,000

Sales returns ... (21,000) 394,000

Less: Gross profit (35% of ¥394,000)... 137,900 (256,100) Ending inventory (unadjusted for damage)... 85,900 Less: Goods on hand—undamaged

(41)

PROBLEM 9-6

STANISLAW CORPORATION Computation of Inventory Fire Loss

April 15, 2011

Inventory, 1/1/11 ... € 75,000 Purchases, 1/1/ – 3/31/11 ... 52,000

April merchandise shipments paid ... 3,400

Unrecorded purchases on account ... 15,600

Total... 146,000 Less: Shipments in transit... € 2,300

Merchandise returned... 950 3,250 Merchandise available for sale... 142,750 Less estimated cost of sales:

Sales, 1/1/ – 3/31/11 ... 135,000 Sales, 4/1/ – 4/15/11

Receivables acknowledged

at 4/15/11 ... €46,000 Estimated receivables not

acknowledged... 8,000 Total... 54,000 Add collections, 4/1/ – 4/15/11 (€12,950 – €950)... 12,000 Total... 66,000 Less receivables, 3/31/11 ... 40,000 26,000 Total sales 1/1/ – 4/15/11... 161,000

Less gross profit (45%* X €161,000) ... 72,450 88,550

Estimated merchandise inventory ... 54,200

(42)

*Computation of Gross Profit Ratio

Net sales, 2009 ... €390,000 Net sales, 2010 ... 530,000 Total net sales ... 920,000 Beginning inventory ... € 66,000

Net purchases, 2009 ... 235,000 Net purchases, 2010 ... 280,000 Total ... 581,000

Less: Ending inventory ... 75,000 506,000 Gross profit ... €414,000

(43)

PROBLEM 9-7

Beginning Inventory ... HK$ 17,000 HK$ 25,000 Purchases ... 82,500 137,000 Freight-in ... 7,000

Purchase returns ... (2,300) (3,000) Transfers in from suburban

branch... 9,200 13,000 Totals ... HK$113,400 172,000 Net markups ... 8,000 180,000 Net markdowns ... (4,000) Sales ... HK$(95,000) Sales returns... 2,400 (92,600) Inventory losses due to

breakage ... (400)

Ending inventory at retail ... HK$ 83,000

HK$113,400 Cost-to-retail ratio =

HK$180,000 = 63%

(b) Ending inventory at LCNRV

(44)

PROBLEM 9-8 Cost Retail Beginning Inventory ... $ 250,000 $ 390,000 Purchases ... 914,500 1,460,000 Purchase returns ... (60,000) (80,000) Purchase discounts... (18,000) — Freight-in ... 42,000 — Markups ... $ 120,000 — Markup cancellations ... (40,000) 80,000 Totals ... $1,128,500 1,850,000 Markdowns ... (45,000) — Markdown cancellations ... 20,000 (25,000) Sales ... (1,410,000) — Sales returns ... 97,500 (1,312,500)

Inventory losses due to breakage... (4,500)

Employee discounts... (8,000) Ending inventory at retail ... $ 500,000

$1,128,500 Cost-to-retail ratio =

$1,850,000 = 61%

Ending inventory at cost

(45)

PROBLEM 9-9

Inventory (beginning)... £ 52,000 £ 78,000 Purchases ... 272,000 423,000 Purchase returns ... (5,600) (8,000) Freight-in ... 16,600 — Totals ... £335,000 493,000 Markups ... 9,000 Markup cancellations... (2,000) 7,000 500,000 Net markdowns ... (3,600)

Normal spoilage and breakage ... (10,000)

Sales ... (390,000) Ending inventory at retail ... £ 96,400

£335,000 Cost-to-retail ratio =

£500,000 = 67%

Ending inventory at LCNRV

(67% of £96,400) ... £ 64,588

(b) The difference between the inventory estimate per retail method and the amount per physical count may be due to:

1. Theft losses (shoplifting or pilferage). 2. Spoilage or breakage above normal.

3. Differences in cost/retail ratio for purchases during the month, beginning inventory, and ending inventory.

4. Markups on goods available for sale inconsistent between cost of goods sold and ending inventory.

5. A wide variety of merchandise with varying cost/retail ratios.

(46)

PROBLEM 9-10

(a) The inventory section of Maddox’s statement of financial position as of November 30, 2010, including required footnotes, is presented below. Also presented below are the inventory section supporting calculations.

Current assets

Inventory Section (Note 1.)

Finished goods (Note 2.) ... $643,000 Work-in-process ... 108,700 Raw materials... 237,400 Factory supplies... 64,800

Total inventories... $1,053,900

Note 1. Lower-of-cost (first-in, first-out) or-net realizable value is applied on a major category basis for finished goods, and on a total inventory basis for work-in-process, raw materials, and factory supplies.

(47)

PROBLEM 9-10 (Continued) Supporting Calculations Finished Goods Work-in-Process Raw Materials Factory Supplies

Down tube shifters at NRV ... $266,000

Bar end shifters at cost ... 182,000

Head tube shifters at cost... 195,000

Work-in-process at NRV ... $108,700 Derailleurs at NRV ... $110,0001 Remaining items at NRV ... 127,400 Supplies at cost... $64,8002 Totals ... $643,000 $108,700 $237,400 $64,800 1_{$264,000 X 1/2 = $132,000; $132,000 ÷ 1.2 = $110,000.} 2_{$69,000 – $4,200 = $64,800.}

(b) The decline in the net realizable value of inventory below cost may be reported using one or two alternate methods, the cost of goods sold method or the loss method. The decline in the net realizable value of inventory may be reflected in Maddox’s income statement as a separate loss item for the fiscal year ended November 30, 2010. The loss amount may also be written off directly, increasing the cost of goods sold on Maddox’s income statement. The loss must be reported in continuing operations. The loss must be included in the income statement since it is material to Maddox’s financial statements.

(48)

PROBLEM 9-11 (a) Schedule A Item On Hand Quantity Cost NRV Lower-of-Cost-or-NRV A 1,100 ¥7.50 ¥9.00 ¥7.50 B 800 8.20 8.10 8.10 C 1,000 5.60 5.45 5.45 D 1,000 3.80 4.50 3.80 E 1,400 6.40 6.00 6.00 Schedule B

Item Cost Lower-of-Cost-or-NRV Difference

A 1,100 X ¥7.50 = ¥8,250 1,100 X ¥7.50 = ¥8,250 None B 800 X ¥8.20 = ¥6,560 800 X ¥8.10 = ¥6,480 ¥ 80 C 1,000 X ¥5.60 = ¥5,600 1,000 X ¥5.45 = ¥5,450 ¥150 D 1,000 X ¥3.80 = ¥3,800 1,000 X ¥3.80 = ¥3,800 None E 1,400 X ¥6.40 = ¥8,960 1,400 X ¥6.00 = ¥8,400 ¥560 ¥790

(b) Cost of Goods Sold... 790

Allowance to Reduce Inventory to NRV... 790 or

Loss Due to Decline of Inventory to NRV ... 790

(49)

PROBLEM 9-11 (Continued) (c)

To: Jay Shin, Clerk

From: Accounting Manager

Date: January 14, 2011

Subject: Instructions on determining lower-of-cost-or-net realiazable value for inventory valuation

This memo responds to your questions regarding our use of lower-of-cost-or-net realizable value for inventory valuation. Simply put, value inventory at whichever is the lower: the actual cost or the net realizable value of the inventory at the time of valuation.

The term cost is relatively simple. It refers to the amount our company paid for our inventory including costs associated with preparing the inventory for sale.

The term net realizable value, on the other hand, is more complicated. As you have already noticed, this value is the estimated selling price minus any estimated costs to complete and sell) the item. This net realizable value is then compared to the actual cost in determining the lower-of-cost-or-net realizable value.

(50)

Proceed in the same way, always choosing the lowest among cost, and net realizable value.

After you have aggregated the total lower-of-cost-or-net realizable value for all items, you will be likely to have a loss on inventory which must be accounted for. In our example, the loss is ¥790. You can journalize this loss in one of two ways:

Cost of Goods Sold... 790

Allowance to Reduce Inventory to NRV ... 790 or

Loss Due to Decline of Inventory to NRV... 790

Allowance to Reduce Inventory to NRV ... 790 This memo should answer your questions about which value to choose when valuing inventory at lower-of-cost-or-net realizable value.

Schedule A Item On Hand Quantity Cost NRV Lower-of- Cost-or-NRV A 1,100 ¥7.50 ¥9.00 ¥7.50 B 800 8.20 8.10 8.10 C 1,000 5.60 5.45 5.45 D 1,000 3.80 4.50 3.80 E 1,400 6.40 6.00 6.00 Schedule B

Item Cost Lower-of-Cost-or-NRV Difference

A 1,100 X ¥7.50 = ¥8,250 1,100 X ¥7.50 = ¥8,250 None

B 800 X ¥8.20 = ¥6,560 800 X ¥8.10 = ¥6,480 ¥ 80

C 1,000 X ¥5.60 = ¥5,600 1,000 X ¥5.45 = ¥5,450 ¥150

D 1,000 X ¥3.80 = ¥3,800 1,000 X ¥3.80 = ¥3,800 None

(51)

TIME AND PURPOSE OF CONCEPTS FOR ANALYSIS

CA 9-1 (Time 15–25 minutes)

Purpose—to provide the student with an opportunity to discuss the purpose, the application, and the potential disadvantages of the lower-of-cost-or-net realizable value method.

Purpose—to provide the student with an opportunity to examine ethical issues related to lower-of-cost-or-net realizable value on an individual-product basis. A relatively straightforward case.

Purpose—to provide the student with a case that requires an application and an explanation of the lower-of-cost-or-net realizable value rule and a differentiation of the FIFO and the average cost methods.

Purpose—to provide the student with an opportunity to discuss the main features of the retail inventory system. In this case, the following must be explained: (a) accounting features of the method, (b) conditions that may distort the results under the method, (c) advantages of using the retail method versus using a cost method, and (d) the accounting theory underlying net markdowns and net markups. A relatively straightforward case.

Purpose—the student discusses which costs are inventoriable, the theoretical arguments for the lower-of-cost-or-net realizable value rule, and the amount that should be used to value inventories. The treatment of beginning inventories and net markdowns when using the conventional retail inventory method must be explained.

(52)

SOLUTIONS TO CONCEPTS FOR ANALYSIS

CA 9-1

(a) The purpose of using the LCNRV method is to reflect the decline of inventory value below its original cost. A departure from cost is justified on the basis that a loss of utility should be reported as a charge against the revenues in the period in which it occurs.

(b) The term “net realizable value” in LCNRV generally means the estimated selling price in the ordinary course of business less reasonably predictable costs of completion and disposal.

(c) The LCNRV method may be applied either directly to each inventory item, to a category, or to the total inventory. The application of the rule to the inventory total, or to the total components of each category, ordinarily results in an amount that more closely approaches cost than it would if the rule were applied to each individual item. Under the first two methods, increases in net realizable value offset, to some extent, the decreases in net realizable value. The most common practice is, however, to price the inventory on an item-by-item basis. Many companies favor the individual item approach because tax rules in certain jurisdictions require that an individual item basis be used unless it involves practical difficulties. In addition, the individual item approach gives the most conservative valuation for statement of financial position purposes.

(d) Conceptually, the LCNRV method has some deficiencies. First, decreases in the value of the asset and the charge to expense are recognized in the period in which loss in utility occurs—not in the period of sale. On the other hand, increases in the value of the asset are recognized only at the point of sale. This situation is inconsistent and can lead to distortions in the presentation of income data.

Second, net realizable value reflects the future service potential of the asset and, for that reason, it is conceptually sound. But net realizable value cannot often be measured with any certainty.

From the standpoint of accounting theory there is little to justify the LCNRV rule. Although conservative from the statement of financial position point of view, it permits the income statement to show a larger net income in future periods than would be justified if the inventory were carried forward at cost. The rule is applied only in those cases where strong evidence indicates that market declines in inventory prices have occurred that will result in losses when such inventories are disposed of.

CA 9-2

(a) The accountant’s ethical responsibility is to provide fair and complete financial information. In this case, the cost of goods sold method distorts the cost of goods sold and hides the decline in market value.

(53)

CA 9-2 (Continued)

(c) Conan should use the loss method to disclose the decline in market value and avoid distorting cost of goods sold. However, she faces an ethical dilemma if Wright will not accept the method Conan wants to use. She should consider various alternatives including the extremes of simply accepting her boss’s decision to quitting if Wright will not change his mind. Conan should assess the consequences of each possible alternative and weigh them carefully before she decides what to do.

CA 9-3

(a) (1) Ogala’s inventory should be reported at net realizable value consistent with the LCNRV rule since net realizable value is below original cost.

(2) The LCNRV rule is used to report the inventory in the statement of financial position at its future utility value. It also recognizes a decline in the utility of inventory in the income statement in the period in which the decline occurs.

(b) Generally, ending inventory would have been higher and cost of goods sold would have been lower had Ogala used the average cost inventory method in a period of declining prices. Inventory quantities increased and average cost associates the all purchase prices with inventory. However, in this instance, there would have been no effect on ending inventory or cost of goods sold had Ogala used the average inventory method because Ogala’s inventory would have been reported at net realizable value according to the LCNRV rule. Net realizable value of the inventory is less than either its average cost or FIFO cost.

CA 9-4

(a) The retail inventory method can be employed to estimate retail, wholesale, and manufacturing finished goods inventories.

The valuation of inventory under this method is arrived at by reducing the ending inventory at retail to an estimate of LCNRV. The retail value of ending inventory can be computed by (1) taking a physical inventory, or by (2) subtracting net sales and net markdowns from the total retail value of merchandise available for sale (i.e., the sum of beginning inventory at retail, net purchases at retail, and net markups). The reduction of ending inventory at retail to an estimate of the lower-of-cost-or-market is accomplished by applying to it an estimated cost ratio arrived at by dividing the retail value of merchandise available for sale as computed in (2) above into the cost of merchandise available for sale (i.e., the sum of beginning inventory, net purchases, and other inventoriable costs).

(b) Since the retail method is based on an estimated cost ratio involving total merchandise available during the period, its validity depends on the underlying assumption that the merchandise in ending inventory is a representative mixture of all merchandise handled. If this condition does not exist, the cost ratio may not be appropriate for the merchandise in ending inventory and can result in significant error.

(54)

Seasonal variations in the rate of markup will nullify the ending inventory “representative mix” assumption. Since the estimated cost ratio is based on total merchandise handled during the period, the same rate of markup should prevail throughout the period. Because of seasonal variations it may be necessary to use data for the last six months, quarter, or month to compute a cost ratio that is appropriate for ending inventory.

Material quantities of special sale merchandise handled during the period may also bias the result of this method because merchandise data included in arriving at the estimated cost ratio may not be proportionately represented in ending inventory. This condition may be avoided by accumulating special sale merchandise data in separate accounts.

Distortion of the ending inventory approximation under this method is often caused by an inadequate system of inventory control. Adequate accounting controls are necessary for the accurate accumula-tion of the data needed to arrive at a valid cost ratio. Physical controls are equally important because, for interim purposes, this method is usually applied without taking a physical inventory. (c) The advantages of using the retail method as compared to cost methods include the following:

1. Approximate inventory values can be determined without maintaining perpetual inventory records. 2. The preparation of interim financial statements is facilitated.

3. Losses due to fire or other casualty are readily determined. 4. Clerical work in pricing the physical inventory is reduced.

5. The cost of merchandise can be kept confidential in intracompany transfers.

(d) The treatments to be accorded net markups and net markdowns must be considered in light of their effects on the estimated cost ratio. If both net markups and net markdowns are used in arriving at the cost ratio, ending inventory will be converted to an estimated average cost figure. Excluding net markdowns will result in the inventory being stated at an estimate of the LCNRV. The lower cost ratio arrived at by excluding net markdowns permits the pricing of inventory at an amount that reflects its current utility. The assumption is that net markdowns represent a loss of utility that should be recognized in the period of markdown. Ending inventory is therefore valued on the basis of its revenue-producing potential and may be expected to produce a normal gross profit if sold at prevailing retail prices in the next period.

CA 9-5

(a) (1) Olson’s inventoriable cost should include all costs incurred to get the lighting fixtures ready for sale to the customer. It includes not only the purchase price of the fixtures but also the other associated costs incurred on the fixtures up to the time they are ready for sale to the customer, for example, freight-in.

(55)

(b) (1) The LCNRV rule is used for valuing inventories because of the concept of conservatism and because the decline in the utility of the inventories below their cost should be recognized as a loss in the current period.

(2) The net realizable value should be used to value the inventories because the net realizable value is less than the cost. To carry the inventories at NRV provides a means of measuring residual usefulness of an inventory expenditure.

(c) Olson’s beginning inventories at cost and at retail would be included in the calculation of the cost ratio.

Net markdowns would be excluded from the calculation of the cost ratio. This procedure reduces the cost ratio because there is a larger denominator for the cost ratio calculation. Thus, the concept of conservatism is being followed and a LCNRV valuation is approximated.

CA 9-6

(a) Accounting standards require that when a contracted price is in excess of market, as it is in this case (market is $5,000,000 and the contract price is $6,000,000), and it is expected that losses will occur when the purchase is effected, losses should be recognized in the period during which such declines in market prices take place. It would be unethical to ignore recognition of the loss now if a loss is expected to occur when the purchase is affected.

(b) If the loss is material, new and continuing shareholders are harmed by nonrecognition of the loss. Herman’s position as an accounting professional also is affected if he accepts a financial report he knows violates accounting standards.

(c) If the preponderance of the evidence points to a loss when the purchase is affected, the controller should recognize the amount of the loss in the period in which the price decline occurs. In this case the loss is measured at $1,000,000 and recorded as follows:

Unrealized Holding Gain or Loss—Income ... 1,000,000